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S Corporation and LLC - Key Differences

Allocation of Income strictly restricted amongst owners / shareholders of an S Corporation

Tax - Lack of Ability to increase pass-through losses in an S Corporation

Restrictions on Ownership

The S corporation limits the type of person or entity that may share in ownership.

Another C Corporation CANNOT be a shareholder / owner of an S Corporation.

Certain trusts cannot be an s corporation shareholder.

An S corporation is limited to 100 shareholders.

A note on filing requirements: Dont forget about state taxes and filings.
Most states, however, conform to the IRS requirements and specifications for an
S Corporation. Some states, however, do require that a separate S Corporation
filng be made at the State level if your corporation is to be considered an
S Corporation for STATE tax purposes.

Allocation of Income

One of the major differences of an S-Corp vs an LLC, is that the S Corporation
is very strict in terms of allocating income amongst shareholders. Each shareholder
shares in the corporation's income in the same proportion as his/her ownership.

An LLC, on the other hand, is very FLEXIBLE in how it owners / members
may allocate income amongst each other. In an LLC, the operating agreement
usually states what share of profits each owner is to receive.

Example: Charlie and Heidi sell Chicken Broth

Charlie and Heidi open a chicken broth factory each owning 50%.
Charlie is the investor and Heidi does all the work. Soon, the business
is more profitable than they had ever imagined. Because Heidi has been
working so hard, and because Charlie has been on vacation for the past
8 months, they agree that Heidi should keep 75% of the profits and Charlie
should get 25%.

In an LLC, this is not a problem. An LLC is very flexible when it comes
to allocation of income amongst owners. Charlie and Heidi simply agree to the
arrangment and they will be taxed according to the income allocated in the operating
agreement.

In an S Corporation, this is a BIG PROBLEM! In an S Corporation, each owner
/ shareholder must share in the income in proportion to his/her ownership. Because
each is a 50% owner, each will be allocated 50% of the corporation's income for
purposes of computing income tax...regardless of any other agreements between the
parties.

S Corporation allows only one class of stock

In an S Corporation, all shareholders own only one class of stock. While it
is permissible to designate voting and non-voting shares, a distinction such as
common stock or preferred stock is not allowed.

Designating different classes of stock becomes important where different
shareholders will begin sharing income differently. In some cases, for example,
a preferred stockholder may receive distributions of income (or assets upon
dissolution) in first priority, leaving remaining assets, if any, to distributed
to common stock shareholders. This scenario is NOT allowed in an S Corporation.

In an LLC, however, these priorities and preferences ARE allowed.

Example: Benny Madlov wants to be a profit partner

“Cash is Us, Inc.” hires Benny Madlov as a salesman to bring in
hedgefund investors. Madlov brings in so much business, that he demands a stock
options and a share of company profits.

In an S Corporation, there may only be one class of stock. So, if he is to
be given shares, they will be of the same class as the other shareholders and
he will be taxed (income will be allocated) proportionally according to his share
of ownership...not based on his sales performance.

In an LLC, the owners / members have the flexibility to create an agreement
that will best motivate Madlov to perform while also providing a level of safety
and comfort to the other owners / LLC members.

Income Tax and Pass-through Losses

In certain circumstances, the IRS allows the loss in a corporation or LLC to
“Pass-through” to the individual shareholders / members. This loss
can then offset other sources of income in effect reducing an individual's overall
tax liability.

For Real Estate owners and investors, these “pass-through” losses
can provide an enormous reduction in tax liability.

If you compare an S-Corp vs an LLC, in an S Corporation, there is a lack of
ability to increase pass-through losses in real estate. In an LLC, however,
there exists an ability to increase pass-through losses.

Real Estate Investments in an LLC

In general, the tax basis for a share in a corporation or LLC is equal to the
investment in the corporation or LLC. In an LLC used for real estate investments,
however, the members are allowed to add the amount of the mortgage to their basis
for the purpose of computing a loss.

Example: Ronald Gump: Gump Towers Goes Upside Down

Ronald Gump invests $10 in Gump Towers. The tax basis is $10. Gump Towers
mortgages the real estate and borrows $20. Rental income and Values decline leaving
Gump Towers with a $20 loss at the end of year one.

Simply stated, Gump has lost $20 through investment activities in real estate.

S Corporation: Because the tax basis for Gump Towers is $10, the IRS will only
allow Gump a $10 loss on his personal income taxes. The remaining $10 loss will be
deferred.

LLC: LLC members are allowed to add the amount of the mortgage to their basis
for purposes of calculating loss. In an LLC, Gump may deduct the entire $20 loss
in year one.